Causes of Nominal and Real Exchange Rate Fluctuations

Causes of Nominal and Real Exchange Rate Fluctuations

Instructions/Descriptions

Critically discuss the causes of nominal and real exchange rate fluctuations, misalignments and the exchange rate policy in Central and Eastern European countries.

RealandnominalexchangerateinTurkeyAssiignment.docx

Running Head: TURKISH EXCHANGE RATES 1

Comment by Microsoft: I mean pot formula inside, is not the simply formula to explain the nominal /real exchange rate.I want formula to explain the point 2， 3 in the courseworkE,g,： NER = i -i* formula to explain the interest rate differentialNER = – *NER = – *NER = My word limit is 2000 (do not include reference), some explanation part could be simplified.

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For example, in introduction u do not need to explain what is nominal/real exchange rate. can directly mention the exchange rate fluctuations in Turkey. Can did like below:“In 2008, both the international financial market and the global economy were turbulent due to the financial and economic crisis.

Causes of Nominal and Real Exchange Rate Fluctuations

This crisis has caused violent exchange rate fluctuations, and lead to an uneven effect on the currencies of major industrial countries. For example, the euro and the dollar move significantly and have experienced appreciation and depreciation. + situation in Hungary + real/nominal exchange rate why important (u did already) + my study is…”

Introduction

A real exchange rate is an economic tool used to measure the price value of goods from foreign countries which are price relative to the value of domestic products. Mathematically this is expressed as the foreign price level ratio to the domestic level price which is achieved by the multiplication of the nominal exchange rate (Calvo et al., 2002). This can be expressed as follows:

R = (E.P*)/P Comment by Microsoft: I feel can use one sentence to explain, do not need to expand like u did. e.g.：real exchange rate equal to nominal exchange rate times foreign price divide by domestic price level, which represent as R=(EP*)/P

Causes of Nominal and Real Exchange Rate Fluctuations

The expression can be elaborated as follows

R- Real exchange rate

E- Nominal exchange rate

P*- Foreign price level

P- Domestic price level

The nominal rate of exchange is an economic tool that is used to measure the currency value of the two countries. This is described as the domestic currency units that can be used in purchasing a given foreign currency unit (Central Bank of the Republic of Turkey., 2006). This can be expressed as follows:

Nominal exchange rate =E= No. of units of C used to purchase a unit of C Comment by Microsoft: same problem like above, use one sentence.

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Whereby

C- Domestic currency C*- Foreign currency

The rates of exchange primarily establish the amount one currency can be used in the exchange of another currency. For instance, the dollar’s exchange rate can determine the worth of a dollar in comparison to a foreign currency. Exchange rates are mostly determined by foreign exchange market in an economy hence these rates are referred to as flexible exchange rates.

There’s the fluctuation of exchange rates from time to time. The flexible exchange rates are determined by the use of forex trade reports that establish the currency worth of country depending on several factors that include, the interest rates of the central bank in the particular nation, the strength of that particular country’s economy and the debt level of the particular country.

Fixed exchange rates exist when the currency of a country doesn’t vary depending on the forex market report. This is established by the country ensuring its currency worth against the major world currencies such as the dollar remain constant, this is achieved by the county selling its currencies in large quantities plus the counter currency to maintain a value that is fixed (Carbaugh, 2014).

The effects of exchange rates are widely felt in a country’s economy. For instance, appreciation of exchange rates leads to a slow-growing rate of real GDP of a country due to decline in net exports which implies a reduction in injections plus rising in imports demand this implies additional leakages in the monetary circular flow.

The demand reduction and output may lead to a loss of jobs as most businesses will need to seek cost control ways (Calvo et al., 2002).

My study focuses on Turkish real and nominal exchange rates for the past decade. For instance, 1 Turkish lira is equivalent to 0.14 dollars. The monetary approach can be utilized in the measurement both the real and nominal exchange rate fluctuations of a county’s currency (Conway, 2014).

Nominal exchange rate fluctuations.

The nominal rate of exchange changes from time to time. The nominal rate of exchange termed as nominal since it only accounts for the currencies numerical value while it doesn’t consider the currencies purchasing power. When a currency exchange rates fluctuate for instance appreciation of a currency means the currency is now more expensive than it used to be.

For example, when the dollar appreciates it implies, we have to use more Turkish lira to buy one dollar hence the rate of exchange from the Turkish point of view. This also implies when the opposite happens and the currency undergoes depreciation then the exchange rate will fall (Gonzalez-Garcia & Cady, 2006).

In Turkey and every other country, persons and companies, banks and other financial institutions plus the government engage in the buying and selling of currencies. Exporters engage in the selling abroad of goods and services while importers are involved in buying abroad.

Causes of Nominal and Real Exchange Rate Fluctuations

Institutions and persons buy foreign currency as a way of investing or the purchasing of financial assets from abroad. Central banks majorly sell and purchase foreign currencies to be able to minimize large fluctuations in exchange rates. All buyers stand for the foreign currency demand while the suppliers are represented by the sellers. This establishes the exchange rates in the price value of foreign currencies in comparison to domestic currency (MacDonald & Stein, 2012).

Comment by Microsoft: There is no trade balance in the graph, if the value for trade balance is too high, and prevent to see more clearly the changes in other variables. Then could probably use two graphs to represent. For example, the first graph with all variables, the second one without trade balance

The implication of nominal exchange rates can be demonstrated, for instance, the nominal exchange rate increase implies that imports will be more expensive while foreigners will get exports cheaper. This leads to a decline in the number of exports and an increase in export amounts consequently this may lead to the creation of employment. Currency depreciation leads to higher inflation rates. This majorly bases on the fact that imports are more expensive while most locally manufactured goods require imports to be fully processed plus tradable goods are expensively sold abroad. The Nominal rate of exchange influence capital flow between countries and rates of interest, this consequently affects, growth of the economy, peoples’ welfare and investments (Carbaugh, 2014).

purchasing power parity

The aspect of purchasing power parity (PPP) establishes that rates of exchange between currencies are an aid to be in equilibrium given their purchasing power is equivalent to each of the two counties. This implies that the rates of exchange in each of the two countries should equate the ratio of goods and services price level in the fixed basket of the two countries.

Hence when there’s price level increase of a domestic country then the exchange should decline to achieve the (PPP). The (PPP) base on the law of one price which has three caveats (Calvo et al., 2002).

• Trade barriers, cost of transport and other costs of the transaction must be significant. Comment by Microsoft: Better not use the bullet point in the paper. I thought this part is not mandatory. Maybe can delete.
• Competitive markets must exist in both countries for goods and services
• On tradable goods are subject to this law.

Interest parity condition

This is an economic tool that is used to establish the movement and values of rates of exchange. (IRP) implies that financial account transactions of a country affect the foreign exchange market in the rate of exchange values. The interest rates parity condition can be termed as the equality condition between two countries’ rates of return regarding comparable asserts (Dinçer & Yüksel, 2019).

Money supply

Monetary policy and nominal exchange rate have an impact in money supply in that, money supply increase makes exchange rates to depreciate. This is primarily due to domestic inflation which makes the domestic county’s goods to be less competitive consequently fall in export demand and low-interest rates increase in money supply makes the interest rates fall (Central Bank of the Republic of Turkey., 2006).

Trade balance

Currency exchange rates are impacted by exchange rates in that the demand and supply can bring about depreciation or appreciation of currencies. For instance, a country that demands high for its domestic goods exports more than it actually imports hence this increases currency demand (EGERT, 2002).

The nominal exchange rate is a mechanism through which monetary policy works as this affects the relative importance of inflation rates and nominal rates of exchange which shapes the response to real exchange rates.

Nominal exchange rates (NER) and future inflation values are greatly dependent on the regime of monetary policy in effect (Giray, 2016).

Comment by Microsoft: Forgot to analysis the result in the graph. Combine the theory and result, whether those variable above could be the reason that lead to percentage change in nominal exchange rate based on the monetary approach.Based on result, whether the monetary approach is useful in explaining exchange rate fluctuations. If not, what are the limitations

Real exchange rates fluctuation

Real exchange rate takes into account the purchasing power of a country’s currency. There’s variance in the real exchange rate if changes are made to:

E- Nominal exchange rate Comment by Microsoft: Do not need

P*- Foreign price index

P- Local price index

The rise in the real exchange rate implies more domestic goods are needed to purchase the same amount of foreign goods. Foreign goods are more expensive with comparison to local goods. There’s the application of Ceteris Paribus by local producers because local consumers might be forced to chose local goods over foreign goods due to the expensive nature of imported goods.

This implies more exports since consumers from foreign countries can be able to substitute imported goods with goods produced locally (Carbaugh, 2014).

The real exchange rate is a crucial factor in competition hence a country’s competitiveness is the capability that enables achieving profitability concerning competitors in international markets. Appreciation in exchange rate favours non-tradable goods productions and imports.

Causes of Nominal and Real Exchange Rate Fluctuations

A real increase indicates real exchange rate increase; with this appreciation the same domestic goods quantity can be used to trade more foreign goods. Depreciation leads to real exchange rate drop (MacDonald & Stein, 2012).

Comment by Microsoft: Same problem, forget to discuss the graph below. Methodology part require theory +data analysis. Beginning use theory to explain (you already did), later on u should check whether the graph u get is consist with hypothesis that based on your theory.

And answer the question whether relative productivity growth rates explain the movements in real exchange rate movementsIs meaningless to put the graph without explanation. Moreover, could explain how u measure relative productivity of tradable goods, use GDP or employment for relative productivity or industrial production

Balassa-Samuelson model

The Balassa-Samuelson effect can be used to determine the change in real rates of exchange. This is termed as productivity considering the purchasing power parity, this is the concept of consumer goods being higher systematically in developed countries more than in third world countries.

The consumer goods prices systematic differences are referred to as “Penn effect”. These model effects are dependent on differences in intercountry in productivity relatively to tradable goods and the non-tradable goods. The Penn effect is established evident in today’s world which implies rapidly developing economies tend to show exchange rates that are appreciating rapidly (Carbaugh, 2014).

Causes of Nominal and Real Exchange Rate Fluctuations

Balassa-Samuelson model has several assumptions that include: Comment by Microsoft: Better not use bullet point, and try to explain it within 2 sentences.

• There’s a positive correlation in relative prices and differential productivities between the two sectors of traded and non-traded.
• Tradable goods assumptions verify the aspect of purchasing power parity.
• There’s a positive correlation between non-tradable goods relative prices and the RER.
• A long term relationship exists between RER and productivity differentials.

Calculation of real exchange rates using nominal exchange rates

Real exchange rate indicates the cost of sold goods in foreign cost and their equivalent cost in local currency (Central Bank of the Republic of Turkey., 2006). Real Exchange rate = (Nominal Exchange rate x Foreign Basket Price)/ Domestic Basket price

R = (E.P*)/P Comment by Microsoft: Already explain in introduction part, do not need to explain again. Either explain here or in introduction.

The expression can be elaborated as follows;

R- Real exchange rate

E- Nominal exchange rate

P*- Foreign price level

P- Domestic price level

Illustration Comment by Microsoft: Is that real number in Turkey？ Better to use the real value in Turkey, and use CPI, PPI, or GDP deflator( as u mentioned below) to do the calculation.

The nominal exchange rate is 10, foreign basket price is 8 and the domestic basket price is 7, determining the real exchange rate is as follows:

Real exchange rate = (10 x 8) / 7 = 11.4

Hence, the real exchange rate is 11.4

Calculation of real exchange rate calculation using price levels

Calculation of Real rates of exchange can be done by using different price indices. These price indices include consumer price index (CPI), gross domestic price deflator (GDP) and also producers price index (PPI) (Giray, 2016).

CPI

This is a price index that measures the change averagely on time in the paid prices by consumers in urban locations for consumer goods and services market basket. This has an advantage over other price indices since it has a possibility of monthly availability in developing countries (Calvo et al., 2002).

PPI

This is a price index that measures the timely average change in received selling prices by goods and services producers. This bases the aspect of change of price based on the seller. The PPI focuses majorly on tradable goods sector but its construction and method of coverage vary from one country to another (Leigh & Rossi, 2002).

GDP deflator

This can be expressed as the ration of nominal concerning real GDP which is one way of price level measurement. The GDP majorly focuses on aggregate production which is comparable between different countries although it includes non-tradable economy sectors. It includes prices of exports while excludes import prices of final goods (Carbaugh, 2014).

The Balassa-Samuelson effect has been effective in explaining XR fluctuations around the globe. Developing country’s economies growth can be attributed to more productivity, land use, labour and capital efficiency.

Causes of Nominal and Real Exchange Rate Fluctuations

This leads to growth in wage in good components in both non-tradable and tradable in an economy. More goods and services are consumed by people leading to an increase in their wages which consequently pushes up prices.

This has a basic implication on a growing economy that its growth can be characterized by a rise in productivity leading to a rise in price levels. Inflation rates remain low in developed economies where an already existing high productivity which isn’t rising as quickly (Giray, 2016).

Turkey’s economy has applied different exchange rates policies in the past decade. There was an economic crisis in Turkey in 2001. After the economic crisis, the floating exchange rate regime was adopted in Turkey. With this regime exchange rates are determined by supply and demand conditions in the market. Several factors determine the rate of the exchange rate in Turkey (Calvo et al., 2002).

• Fiscal and monetary policies Comment by Microsoft: Do not use bullet point. could list in one sentence.
• Economic infrastructure
• Expectations
• International developments

The Central Bank of the Republic of Turkey (CBRT) doesn’t set either real or nominal exchange rate since the exchange rate isn’t used as policy technique in the regime of floating exchange rate (Leigh & Rossi, 2002). Financial stability risks are reduced by the CRBT taking precautions against the Turkish lira excessive decline and appreciation.

Causes of Nominal and Real Exchange Rate Fluctuations

The CRBT has a responsibility of managing and keeping Turkey’s gold reserves plus Turkey’s foreign exchange reserves. International reserves can be termed as readily usable assets which are acceptable as a form of international payment, these reserves are normally controlled by monetary authorities of the country which can be converted into other currencies.

The CRBT is tasked with the determination and implementation of exchange rates regime in Turkey in collaboration with the government. The regime of floating rate of exchange has an impact on the fundamental of macroeconomics in countries which have an impact on the rate of exchange of international markets which affects flows of portfolios between countries.

This has greatly enhanced market efficiency (MacDonald & Stein).

The floating exchange has been key during crisis and post-crisis periods in determining both nominal and real exchange rates. This kind of regime is a fluctuating exchange rate where the values of currencies are allowed to go with the rate of the foreign exchange market.

Floating exchange rates are termed as the best regime of the exchange rate since it makes it possible for a country to be able to dampen shocks impact with relation to foreign business cycles hence preempting the balance of payment crisis possibility. Currency crisis avoidance using preventive measures is the best solution to the aspect of the currency crisis.

Causes of Nominal and Real Exchange Rate Fluctuations

Floating exchange rate avoids currency crisis by making sure the market sets the price contrary to fixed exchange rates whereby central banks are involved in fighting the market. During the crisis, the floating exchange rate allows facilitation in the adjustment of external shocks which buffers their effect on economic activities.

This contributes to policy effectiveness and clarity that brings independence in monetary policy hence domestic stability in prices is achieved. This promotes development in the financial sector after a currency crisis in both nominal and real exchange rates (Carbaugh, 2014).

Causes of Nominal and Real Exchange Rate Fluctuations

References

Calvo, M. G., Kumhof, M. M., & Celasun, O. (2002). Nominal exchange rate anchoring under inflation inertia. International Monetary Fund.

Carbaugh, R. (2014). International economics. Cengage Learning.

Central Bank of the Republic of Turkey. (2006). Annual report.

Conway, P. (2014). Economic shocks and structural adjustments: Turkey after 1973. Elsevier.

Dinçer, H., & Yüksel, S. (2019). Handbook of research on decision-making techniques in financial marketing. IGI Global.

EGERT, B. (2002). The balassa-Samuelson effect in central and Eastern Europe.

Giray, K. (2016). Masterpieces from the Central Bank of the Republic of Turkey art collection.

Gonzalez-Garcia, J., & Cady, M. J. (2006). The IMF’s reserves template and nominal exchange rate volatility. International Monetary Fund.

Jha, R. (2003). Macroeconomics for developing countries. Routledge.

Leigh, D., & Rossi, M. (2002). Exchange rate pass-through in Turkey. International Monetary Fund.

MacDonald, R., & Ricci, L. A. (2001). PPP and the Balassa Samuelson effect: The role of the distribution sector. International Monetary Fund.

MacDonald, R., & Stein, J. L. (2012). Equilibrium exchange rates. Springer Science & Business Media.

Veltri, J. R. (2001). Estimating an equilibrium real exchange rate for the Turkish lira.

YearD.interest rate D.inflationD.monetary growthTrade balancepercentage change in norminal exchange rate

Causes of Nominal and Real Exchange Rate Fluctuations

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